A Manufactured Crisis

Earlier this year, the New York Times ran a front-page story about the outrageous pensions being paid out to a few Oregon retirees. The story, headlined “A $76,000 Monthly Pension: Why States and Cities Are Short on Cash,” featured a former college football coach collecting more than $550,000 a year, and a retired university president pocketing $913,000. The story feeds into a popular myth that retired public-sector workers are getting fat and rich thanks to ordinary taxpayers, who are shouldering the costs of pensions so generous they have triggered a cascade of fiscal crises.

In reality, most retired public workers are living far more modestly. In 2014, the suburban Chicago Daily Herald looked at nine statewide and local pensions, including those enjoyed by teachers, legislators, and university professors. The average pensioner, they found, received $32,000 a year. The Illinois municipal retirement fund pays an average pension of only $22,284 a year, low enough for seniors to qualify for food stamps. Most retired civil servants, moreover, don’t receive Social Security. Despite the rhetoric, public workers are generally paid less than their private-sector counterparts, even when factoring in benefits — 11 to 12 percent less, according to a 2010 analysis of two decades of data from the Bureau of Labor Statistics.

The Illinois Policy Institute, a conservative think tank with offices in Chicago and Springfield, is one of several organizations that have helped exaggerate the pension crisis myth. Its specialty has been manipulating the numbers to make the state’s pension problems seem even more outsized than they are. Illinois is facing, according to the Chicago Federal Reserve, a substantial unfunded $129 billion pension liability. But Ted Dabrowski, then the group’s vice president for policy, told me, “The state’s really looking at a deficit of $250 billion,” a figure he reached by making the unlikely assumption that the state invested only in low-yield bonds. Yet such research provides the ballast for attacks on pensions by organizations such as the Civic Committee of the Commercial Club of Chicago, a group made up of some of the city’s wealthy, politically active business leaders. The committee uses its influence to push a message that cutting public pensions is critical to Illinois’s well-being.

A Houston couple, John and Laura Arnold, cut a high profile among those interested in public pensions. John Arnold used money he made as an energy trader at Enron to start a hedge fund in 2002. He was worth in the multiple billions by 2010 when he created the Laura and John Arnold Foundation, which since its inception has been funding research and campaigns around the United States aimed at sounding the alarm about public pension debt and driving public pension reform. Among the foundation’s biggest gives: $9.7 million to the Pew Charitable Trusts for work on public-sector retirement systems; Pew, in turn, has produced its own headline-generating reports about a rising pension crisis. The Arnolds also personally wrote a $5 million check to a PAC called IllinoisGO, which lists as its purpose giving Democrats who support “difficult, yet responsible choices” political cover from “special interest attacks.” (The foundation also coproduced a report with Pew that raised concerns about pension funds moving into high-fee alternatives.)

Almost no pension system, public or private, is 100 percent funded. But a system doesn’t need full funding, unless every person retired tomorrow. Eighty percent is the threshold the federal government uses when assessing the health of the corporate pension plans it monitors. The credit reporting agencies also employ the 80 percent benchmark as an indicator of financial soundness — if not a lower figure. Fitch Ratings, for instance, “generally considers a funded ratio of 70 percent or above to be adequate.” By those standards, the country’s public pensions are generally doing fine — funded, on average, at 76 percent, according to a survey by the National Conference on Public Employee Retirement Systems. “Seventy-six percent is healthy,” according to Bailey Childers, former executive director of the National Public Pension Coalition, “so long as states keep up their contributions and the investments are managed responsibly.”

Those who care about carefully assessing the health of the country’s public pensions would need to take into account Wisconsin, South Dakota, and New York, three states where the pension system is over 90 percent funded. They would need to consider Texas, Oregon, Ohio, Florida, or any of a long list of states whose pensions systems are more than 70 percent funded. Except those states don’t fit the narrative being put forward by those seeking to manufacture a crisis to justify wiping out public pensions. That’s why Illinois looms large, along with Kentucky, New Jersey, and a few other states where there’s no denying the systems are in crisis. There first needs to be a crisis to convince people that the problem requires a drastic fix.

Exploiting the Pension Crisis

The governor of Illinois, Bruce Rauner, has been a leading champion of the pensions-in-crisis narrative. Even before he entered the race for governor in 2013, he was outspoken in his belief that the public employee unions were a major reason, if not the top reason, Illinois was in an economic “death spiral.” He was also one of several wealthy corporate executives in Chicago behind a successful effort in 2011 to make it harder for teachers in the state to strike. One of Rauner’s first acts after taking over as governor was to issue an executive order allowing state employees who didn’t want to pay union dues to opt out; he later instructed state agencies to stop collecting the fees on behalf of the unions. That gave rise to the Supreme Court’s Janus ruling, which dealt a crippling blow to public sector unions when it was decided this past June. It was Rauner who preemptively filed suit in an effort to get the case quickly in front of the U.S. Supreme Court. But a judge ruled that he didn’t have standing, so a state worker named Mark Janus became the lead plaintiff in a case Rauner would hail as a “great victory for our democracy, our public employees and the taxpayers.”

Rauner’s most prominent public-sector position prior to his run for governor was as an adviser to Chicago Mayor Rahm Emanuel. The two had first met in the late 1990s, shortly after Emanuel left the Clinton White House and around the time Emanuel was brought on as a partner at the investment bank Wasserstein Perella & Co. The young politico famously earned $18.5 million during his two-and-one-half years there — much of it courtesy of his business relationship with Rauner. The two did five deals together, including SecurityLink, an alarm company Emanuel brought to Rauner for acquisition. Rauner’s private equity firm GTCR bought the company from SBC Communications for $479 million, then sold it six months later for $1 billion. Shortly after he was elected mayor, Emanuel put Rauner and his wife into what the Chicago Tribune called “unpaid but prominent advisory roles.” Rauner left GTCR in October 2012 and announced that he was running for governor in June 2013.

As soon as Rauner took office, he sought to slash pension benefits, traveling the state to push a plan calling for $2 billion in pension cuts (though he promised to exempt police and firefighters). He stopped only when the Illinois Supreme Court slammed the door on that idea, reminding him that the state constitution included an ironclad provision declaring public pensions an enforceable contractual relationship, “the benefits of which shall not be diminished or impaired.” The justice writing for the 7-0 majority, a Republican appointee, seemed to be talking directly to Rauner when he wrote, “Crisis is not an excuse to abandon the rule of law. It is a summons to defend it.”

Illinois ranks in the bottom third among state spending on core services as a share of state GDP, according to the Chicago-based Center for Tax and Budget Accountability. The state couldn’t afford to shrink the size of government any further, Ralph Martire, the center’s executive director, argues, but the new governor proposed doing just that, with deep cuts not only to pensions, but to public services. For good measure, Rauner used his first State of the State address to propose that public unions be banned from contributing to the campaigns of state legislators and signed an executive order prohibiting public unions from collecting fees from government workers who choose not to join.

The American Federation of Teachers keeps what it calls a “watch list”: those managing their members’ money who in turn write big checks to organizations seeking to “reform” the country’s public pensions — which is to say, to eliminate them. Rauner deserved a “special mention” in AFT’s 2018 report for fighting the battle not just from the governor’s mansion, but also with his checkbook. That included the $500,000 Rauner gave, through his family foundation, to the Illinois Policy Institute. (Rauner also employed several staffers from the institute, including one as his chief of staff, until his relationship with the institute unraveled late last year.)

“The anti-pension people love this guy,” said Daniel Montgomery, president of the Illinois Federation of Teachers. The Rauner campaign declined to comment for this article.

Aiding Rauner’s cause has been the scandal that rocked the $51.5 billion Illinois Teachers’ Retirement System, or TRS. Illinois is home to one of the pension funds that might be called the “overextended”: funds that devote more than 30 percent of their assets to alternatives, the investment world’s catch-all term for private equity, hedge funds, and other complex investments. TRS has an astonishing 38 percent of its holdings in alternative investments — among the highest in the country. At that point, a fund isn’t so much investing as making casino-like desperation bets to try to make up for pension underfunding, as well as for past investment mistakes and bad deals. Those with the highest exposure to high-fee alternatives are also the most vulnerable to pay-to-play. Not surprisingly, TRS has been spectacularly marked by corruption.

Public Pensions Have Been Very, Very Good to Bruce Rauner

While Rauner has fiercely attacked public pensions, public pensions have been very good to Rauner. He owns no less than three homes in the Chicago area: a 6,900-square-foot palace in a tony suburb just north of the city and a pair of units downtown, including a penthouse overlooking Millennium Park that is just a short walk to the private equity firm that has made him so wealthy. There, the fees that for years his private equity business charged public pensions mean that, during Chicago’s brutal winters, he and his wife can choose between the waterfront villa they own in the Florida Keys and a $1.75 million condo at a Utah ski resort. Other options include the sprawling property the couple owns near Yellowstone National Park in Wyoming, a pair of ranches in Montana, or the penthouse overlooking New York’s Central Park that they bought for $10 million. When this little-known prince of private equity announced his candidacy for governor in 2013, the Chicago Tribune compared him to an earlier private equity governor who was so rich, it was often viewed as a political liability. Yet whereas Mitt Romney owned six homes, Rauner had nine.

Montgomery, of the teachers union, said that while Rauner and the other two private equity governors in the United States like to “brag about all the money they made for teachers, like they’re do-gooders working in a soup kitchen or something. The part they never tell you about are the multimillion dollars they charge each pension for providing all this help.”

Rauner’s former firm GTCR is one of the thousands of private equity partnerships in the United States that collectively manage hundreds of billions of dollars. GTCR raised a $3.25 billion fund in 2011; another $3.85 billion for its 11th fund, GTCR XI, which closed in 2014; and another $5.25 billion last year for GTCR XII. The general partners, as those who run a private equity firm are called, might throw a bit of their own money, but it’s the “limited partners” who provide the bulk of the cash that firms use to buy up and invest in promising businesses they find.

The universe of limited partners includes foundations, university endowments, wealthy individuals — and pension funds. Rauner once estimated that pensions accounted for half to two-thirds of the money he and his partners had raised.

The pensions truly are limited partners. They write checks but remain passive investors who receive occasional reports about how everything is going and maybe an invite to an annual gathering, where the general partners typically try to wow pension staffers and trustees, some of whom might welcome a free trip to some enviable destination.

There are two primary ways that fund managers get rich off the country’s pensions, a pot that exceeds $10 trillion, including both public and private funds. First are the management fees that any private equity firm, venture capital firm, or hedge fund charges. That’s the money the firm takes off the top to keep the lights on and pay their own salaries, along with those of the analysts and others they have in their employ. According to Crain’s Chicago Business, GTCR takes 1.5 percent, rather than the more customary 2 percent, but that’s still a comfortable amount. At that rate, GTCR would take in $75 million on a single $5 billion fund. Every successful investment ends with the “liquidity event” that lets everyone get paid — a company goes public, say, or sells to a larger enterprise. Typically, the partners take a 20 percent share of that revenue, called “the carry,” before passing along the remaining profits to the limited partners.

How much can “the carry” mean for a firm’s partners? In 1999, Rauner told the Chicago Sun-Times that his firm had generated annual returns of 40 percent over the previous 19 years. After fees, he said, his limited partners averaged an annual return of 30 percent. Anecdotal evidence would suggest that Rauner was exaggerating somewhat. Data from the Washington State Investment Board, a longtime limited partner in Rauner’s firm, published by Fortune in 2011, showed that investors in GTCR’s seventh fund (2000) earned an annual 22 percent over 10 years, while its eighth fund (2003) was providing a return of 27 percent a year. That’s far higher earnings than a safe government bond. But look at the take for the private equity partners: Even a $2 billion fund like GTCR VII earning 22 percent a year would have generated roughly $12 billion in profits over 10 years. GTCR’s cut on such an investment, assuming the standard 20 percent carry, would have been $2.5 billion.

But there’s evidence that private equity firms aren’t satisfied with even those extraordinary profits. The Dodd-Frank financial reform required the Securities and Exchange Commission to more closely monitor private equity firms, which the SEC began doing in 2012. Two years later, the SEC revealed that of the roughly 400 private equity firms the agency had examined, more than half had either charged unjustified fees and expenses, or didn’t have the controls in place to prevent such abuses. Many were inflating the fees they charged, Mary Jo White, then chair of the SEC, told Congress, “using bogus service providers to charge false fees in order to kick back part of the fee to the adviser,” which is to say, themselves. A year later, two giants of private equity were fined for bad behavior. Blackstone paid nearly $39 million to settle an SEC investigation into such unfair practices as failing to disclose that it had negotiated a discounted rate from an outside law firm that continued to charge its limited partners much higher price. KKR paid almost $30 million to settle charges that it unfairly required its limited partners to shoulder the cost of $338 million in “broken deal” expenses — having failed to allocate any of these expenses to the general partners for years.

A new law in Illinois, passed after former Gov. Rod Blagojevich’s impeachment and imprisonment, imposed strict new campaign contribution limits. An exception was made, however, for the wealthy. If a candidate spends $250,000 or more on their own race, the caps are lifted for everyone in that race. Rauner gave $27.5 million to his own campaign and raised millions more from a coterie of moguls, including fellow Chicagoans Sam Zell and Kenneth Griffin, a hedge fund manager who ranks as Illinois’s richest person. The New York Times’s Nicholas Confessore, who in 2015 investigated the outsized influence of just 158 wealthy families on politics, found that the $13.6 million Griffin and his family contributed to Rauner in 2014 was more than 244 labor unions donated, combined, to his Democratic opponent.

Rauner’s opponents in both the primary and general elections sought to use wealth and his private equity record against him. One ad that aired during the Republican primary featured the death of three women at a pair of nursing homes linked to GTCR — GTCR had co-founded their parent company, and Rauner sat on its board. (The Rauner campaign called the ads “shameful” and noted that the company GTCR had helped found was bankrupt and in receivership by the time of the three deaths.) The Daily Herald discovered that Rauner was claiming tax breaks on three of his homes, though he was entitled to use only one for an exemption. (Rauner paid the back taxes he owed on the extra exemptions.) Other coverage showed that he had falsely claimed residency in Chicago when his daughter sought to attend a well-regarded public high school in the city and then made a $250,000 donation to the school after she was accepted. (“My daughter was highly qualified to go to that school,” Rauner said during the campaign.) The Chicago Tribune found SEC filings showing that GTCR had no less than six investment pools registered in the Cayman Islands, collectively worth hundreds of millions of dollars. “Bruce Rauner makes Mitt Romney look like Gandhi,” a former general counsel for the Illinois Republican Party said that fall.

Rauner won every county in the state outside of Cook County, home to Chicago. His attacks on the state’s public pensions did little to undermine him — in no small part because his opponent, incumbent Pat Quinn, had himself championed a 2013 law that attempted to squeeze cost-of-living increases for retirees. (An orange snake dubbed “Squeezy the Pension Python” represented the pension in one of Quinn’s political ads.) Yet this was still deep-blue Illinois. Though Rauner had said the state should cut a dollar from its $8.25 an hour minimum wage, voters approved an advisory ballot initiative calling on lawmakers to raise it. Though Rauner had campaigned against another initiative calling on Springfield to impose a 3 percent tax on income over $1 million, the millionaire’s tax passed with 60 percent of the vote.

Officials Used Pensions Like a Credit Card

The first time a commission was appointed to investigate Illinois’s pension crisis was in 1913. Apparently, lawmakers failed to learn any lessons. For 78 years running, Tyler Bond of the National Public Pension Coalition pointed out in 2017, the state had failed to meet its full pension obligations. Teachers were given no choice: 9.4 percent of their salary was withheld each year for their pension. Roughly similar proportions were deducted from the pay of other state employees. Yet for nearly eight decades, the state had simply failed to make its mandated contributions to all five of its public pensions.

“Elected officials used the pension system like a credit card,” said Martire of the Center for Tax and Budget Accountability. That way lawmakers could keep taxes relatively low without cutting services. “They basically said, ‘Somebody down the road is gonna have to pay for this, but by then I’ll be out of office, so I don’t have to worry about it.” The unpaid bill as of earlier this year was $129 billion and counting.

The teachers’ pension, TRS, accounts for roughly $73 billion of those unfunded liabilities, according to TRS’s own analysis.  But that underfunding became a true disaster in 2008, after the stock market’s great slide. The fund lost nearly $10 billion in the crash — more than a third of its value at the time. But rather than pursuing a path that stressed plain vanilla investments, the fund’s trustees upped its exposure to high-fee, high-risk investments.

The Illinois State Board of Investment, which oversees investments made by the state employee pension fund, took a similar path. The pension, which covers such public employees as DMV clerks, highway repair crews, and prison guards, more than doubled its exposure to hedge funds between 2007 and 2015, from under 4 percent to 10 percent. The board paid around $331 million in fees to hedge fund managers during that period, according to a study by the Roosevelt Institute and the American Federation of Teachers called “All That Glitters Is Not Gold” — compared to an estimated $37 million the board would have paid to manage the same size portfolio if it had been invested in stocks or bonds. The board’s hedge fund strategy, according to the report, cost the pension some $123 million in lost investment revenue during those years.

A new chair took over in 2015, however, and since that time ISBI has withdrawn its money from 65 hedge funds. Less than 1 percent of its money remains with hedge funds, and just 3.3 percent in private equity, including several million dollars with GTCR that is left over from the tens of millions of dollars it had invested over the years in several GTCR funds. Last year, the pension announced that nearly half of its $18 billion fund was invested in low-cost index funds, saving the fund $50 million in fees over two years, the fund’s chief investment officer said, while also “increasing expected returns.”

Illinois has hundreds of public pensions, more by far than any other state in the country. As of 2016, it had more than 650 locally controlled funds created for firefighters and police not covered by the Illinois Municipal Retirement System — and too small, said James McNamee, founder and president of the Illinois Public Pension Fund Association, to risk getting involved in private equity or other alternatives. A former police officer who served as a trustee of his pension fund in a small Chicago suburb, McNamee created the association in part to help inoculate his peers from high-fee, high-risk investments that he believes are not appropriate for funds under $1 billion. “A lot of what we do is educate trustees,” McNamee said, “because we know there are people out there who want to talk them into things they shouldn’t do.”

Some larger funds in the state have exercised this same caution, such as the Illinois Municipal Retirement Fund, which Forbes once called the gold standard for other pensions in the state. Its advantage relative to other pensions is that the state collects a fee from participating governments each year, guaranteeing that its funding obligations are met. It has just 3.2 percent of its money invested in private equity and another 6.2 percent dedicated to real estate investments.

Others, such as the State University Employees System, continue to gamble. At $21 billion, SURS is the state’s second-largest pension and accounts for $23.4 billion of the state’s pension shortfall. As of 2017, SURS still had 5 percent of assets in hedge funds, 6 percent in private equity, and 10 percent in real estate. “States that tend to be in more financial difficulty tend to have higher-risk portfolios,” said Bill Bergman, an economist and the director of research at the Chicago-based Truth in Accounting, a nonprofit that pushes for transparency in government financing, told the New York Times in 2017. “In Illinois, the defense is that in the long run, these investments will be good for us. But they’re expensive, opaque, and risky.”

Corruption seemed inevitable with so much money at stake. A former TRS trustee named Stuart Levine, who in 2012 was sentenced to five and a half years in jail, was charged with soliciting kickback payment from investment firms seeking a share of the pension’s assets. An outside counsel to the pension admitted that he helped Levine use the pension’s money to reward major campaign contributors to Blagojevich, who in 2012 was sentenced to 14 years in prison for a range of public corruption charges. Also caught up in the probe was a Chicago lawyer who was previously finance chair for the Democratic National Committee. He confessed that he played intermediary for a Virginia-based investment fund seeking advice on how the backdoor system worked: In exchange for TRS investing $85 million in their firm, he explained, a kickback of $850,000 was customary. To make that happen, the lawyer suggested helpfully, they could enter into a sham consulting contract to disguise the payoff, adding, “This is how things are done in Illinois.” Another federal indictment, handed down in 2009, spelled out how a well-known Springfield power broker used his “longstanding relationships and influence with trustees and staff members” at TRS to steer funds to favored money managers. He would be sentenced to a year in prison and fined $75,000.

Rauner was tied to the scandal through Levine. The two first encountered one another when in 2003, Rauner and his partners were raising GTCR XIII and Levine objected to the TRS board investing $50 million in the fund. The deal was tabled but sailed through a few months later, after Rauner showed up personally at a TRS board meeting. A later corruption probe revealed that CompBenefits, a company partially owned by GTCR, was paying Levine $25,000 a month as a “consultant.” TRS didn’t invest any more money with Rauner’s firm after Levine’s arrest in 2006.

Yet the scandals sparked no great moral shift inside TRS. Barely one year after it had been caught siphoning off fees from its limited partners, the TRS board voted to commit more money to Blackstone, on top of the $165 million it already had invested with the marquee firm. Another behemoth of the private equity world, the Carlyle Group, had been exposed paying a lobbyist millions of dollars starting in 2002 to win TRS business and paid $20 million in fines in 2009 for its involvement in a pay-to-play pension scandal in New York. Yet since 2013, TRS’s trustees have entrusted $255 million in pension dollars to Carlyle. Altogether, over the past 10 years, TRS investments in private equity have more than doubled. Its investments in hedge funds have more than quadrupled.

“It’s a vicious cycle,” said Fred Klonsky, a retired public school teacher who writes an education blog that covers the sorry state of his pension. “The more we’re falling behind, the more and more percentage of the fund that goes into high-risk investments in pursuit of big returns.” So far, it hasn’t proven a disaster. TRS has posted a respectable annual return of 6.6 percent in recent years. But that means TRS is paying exorbitant fees just to reach the national average — 6.6 percent was the average yield Pew found when it compared the performance of the 73 largest state pensions over a 10-year period.

“It’s an age-old debate about whether it’s appropriate for pension to use alternatives or not,” TRS communications director Dave Urbanek said. “Our board is very comfortable with our asset mix, which has been designed to reduce risk in the next downturn in the stock market,” he added, noting that KRS posted an 8.5 percent return in the most recent fiscal year.

Yet the veiled nature of alternative investments still troubles Klonsky. “There’s a level of secrecy, a lack of transparency that I don’t like,” Klonsky said. “There’s basic information that we can’t get. How much in fees are we paying? I look at the trustees and they don’t want to seem to get directly involved in determining the direction of investments. Instead what happens is they hire somebody who brings in consultants, and more and more of our money ends up going into this stuff.”

The Trouble With Private Equity

On the campaign trail in 2014, Rauner liked to describe himself as the grandson of a Swedish immigrant who worked at a Wisconsin cottage cheese factory and lived in a double-wide trailer. Missing were his years growing up in Lake Forest, a wealthy suburb north of Chicago, the son of a top executive at Motorola. Rauner rowed crew at Dartmouth, where he studied economics, and earned his MBA at Harvard. He graduated in 1981 and moved to Chicago to take a job at Golder Thoma Cressey, or GTC, a private equity firm founded two years earlier by a trio who had worked together at one of the city’s top banks. A decade later, Rauner became a named partner and an R was added to the firm’s acronym. It was now GTCR.

Private equity firms invest in businesses in exchange for an ownership stake, like venture capitalists, or buy up struggling businesses that the partners think they can turn around. Over the years, GTCR seemed to specialize in the dull and ordinary. It invested in outdoor advertising, hospital management, steel tube manufacturing, fleet refueling, check authorization, and funeral homes because, Rauner once told a reporter, it produces profit margins of 35 to 40 percent and is “immune to downturns.” Rauner and his partners were similarly drawn to the coin-operated laundromat business because of what he described as a “locked-in customer base.” “If prices go up, the tenants still use it,” Rauner said.

Private equity is GTCR investing $7 million in a company called American Medical Lab and making $200 million when Quest Diagnostics buys the company for $500 million five years later in 2002. Or, as Rauner boasted about in a 2003 interview with Crain’s Chicago Business, paying $100 million to buy a subsidiary from one large company and selling it to another six months later for nearly $500 million.

Other investments fail. That’s private equity, too: dropping $200 million on a company or a sector that collapses.

Then there are the deals that really give private equity a bad name — and make it a questionable way to invest public pensions. A health care company GTCR bought in 1998 was accused of stripping resources from the chain of nursing homes it owned — and then sued over its alleged participation in a scheme to avoid liability for a string of deaths. Another GTCR-owned company providing telephone services to the hearing- and speech-impaired paid $15.75 million to settle allegations by the Federal Communications Commission that it had overcharged customers. The SEC and Department of Justice caught another GTCR-backed company using a Bermuda-based subsidiary to skirt domestic stock-trading laws. Rauner’s firm extracted $9 million in cash from one of its portfolio companies right as the company was heading into bankruptcy, but was later ordered to pay more than two-thirds of it back.

Job losses are common when private equity firms implement “efficiencies.” In 2008, a GTCR-backed company that provides airport services snapped up several smaller rivals, including one operating a small regional airport outside of Chicago. At that one airport, the executive director of the operating agency said, the transition “from a small family business to a large corporate chain” translated into “a 30 percent reduction in workforce.” It’s also not uncommon for private equity to load up companies they buy with so much debt that they collapse under their own weight. In 1999, GTCR sold a Dallas-based wireless concern to a larger company — another big revenue generator that earned the firm more than $500 million on an $8 million investment. Yet the sale left the wireless company so freighted with debt that it was forced into bankruptcy shortly after the sale.

Private equity is a game of winners and losers, and the extent of Rauner’s winnings became clear only once the financier-turned-candidate released excerpts of his tax returns. The Rauners claimed a mere $28 million in income in 2011 and $27 million in 2010, but made up for down years with $53 million in 2012. Because of the carried interest loophole, Rauner likely paid only 23.8 percent in federal taxes on the bulk of his earnings — 40 percent less than what he would have paid if his earnings had been taxed as income.

A Black Box

The track record of firms such as Rauner’s has spurred some to question whether private equity, even when it outperforms other assets, is appropriate for a pension fund. Among them is Edward Siedle, a former SEC attorney who has been hired by a variety of public and private pensions to examine their portfolios. “It’s the public’s money being invested, yet the contracts with private equity firms routinely forbid an investor from sharing details about their holdings,” Siedle said.

These investments are so opaque that a top executive at the California Public Employees’ Retirement System confessed in 2015 that he had no clue how much in fees they were paying to private equity firms each year.  The answer CalPERS arrived at several months later was an eye-popping $1.1 billion in the prior fiscal year. Private equity funds typically require nondisclosure agreements — problematic for an investment involving public funds — and the contracts are so one-sided as to be comical. A contract the Kentucky Retirement System inked with Blackstone, a giant of the private equity world, waives any liability on the part of the firm for engaging in financial conflict of interests. Another provision dictated that if management is sued, the costs “would be payable from the assets of the Partnership” — in other words, pensions and other investors would pick up the costs, not the general partners.

Hedge fund investments carry the same baggage. The contract a pension signs with a hedge fund typically forbids pension officials from revealing much, if anything, about the investment, even to the public employees on whose behalf a trustee is investing. The pension fund trustees who have decided to avoid buying stock in a gun maker, say, might not know that it owns some anyway through a hedge fund. More than 20 pension funds were in a fund of funds that included SAC Capital, the infamous hedge fund run by Steven Cohen, before the firm paid $1.8 billion in fines for insider trading and shut its doors.

For a fund like TRS, these provisions mean nearly 40 percent of its portfolio “operating entirely outside of scrutiny,” said Siedle, who refers to private equity as a “black box.” A firm might claim $200 million in profit on a $500 million deal, but how many millions were already siphoned off by means of “monitoring fees” partners pay themselves for dispending their wisdom to their portfolio companies, or “accelerated monitoring fees,” the lump sum partners charge their portfolio companies if a quick sale cheats them out of several years of lucrative consulting services? “Private equity managers are the most secretive money handlers out there, charging extra fees wherever they can, running these opaque, illiquid, hard-to-value private investments,” Siedle said.

It irked Siedle that both Rauner and Romney were able to run for public office “without disclosing how they made whatever money they have stashed offshore.” Perhaps that’s why Siedle chose to publicly dissect GTCR’s most recent SEC filing on the Forbes website one week before the 2014 gubernatorial election. In the filing, the GTCR partners lay out some of the special provisions they’d granted themselves. For instance, they had given themselves the right to create a special “family and friends” side fund that invests alongside the firm’s main funds. Those designated friends of the firm would be allowed to invest on better deal terms than those granted to other limited partners, or sell an asset to the main fund on terms determined by the partners. “Selling the laggards to other GTCR funds in which public pensions invest? Seems possible based upon the firm’s SEC filings,” Siedle wrote. Additional language freed the firm to bill the limited partners for any consulting services they deem necessary “even if another person may be more qualified to provide the applicable services and/or can provide such services at a lesser cost” and allows them to “withhold information from certain limited partners or investors,” including from entities “subject to [the] Freedom of Information Act.” Siedle then lists some of the massive public pensions that have entrusted GTCR with their money, including TRS in Illinois, and various state pensions in New Mexico, Pennsylvania, Massachusetts, Louisiana, and New York. “Why would dozens of public pensions,” Siedle asked, “agree to obviously unfair treatment?”

Randi Weingarten, president of the American Federation of Teachers, asked the same question, though her preoccupation is with pensions investing in private equity and hedge funds who financially support organizations that hurt labor. It was six years ago, Weingarten said, that the union launched an initiative to educate teachers’ pension trustees around the country about this risk. The union started holding seminars for trustees and producing a periodic “Assets Manager” report, the most recent of which, published in March, singles out 21 money managers who are rich in no small part because of the money they made off public pensions — yet now support organizations calling for pensions’ elimination. Several are generous donors to conservative think tanks such as the Manhattan Institute and Reason Foundation, both of which have staked out pensions as an issue. “Teachers collectively have influence over trillions of dollars in assets,” said Weingarten, “and we intend to use it.”

Lower fees might be one answer. In 2017, the union released a report called “The Big Squeeze” that looked at 12 of the country’s largest public pensions. Cut in half the fees charged by private equity and hedge funds, the AFT found, and the average fund looked at would have an additional $360 million a year to invest. Looking ahead 30 years, and assuming an annual interest rate of 6.6 percent, the average return for a large public pension in the U.S., according to Pew — that means an additional $2-plus billion for every $350 million saved.

How to Prolong a Crisis

Rauner had been governor less than six months when the Illinois Supreme Court thwarted his effort to slash the retirement benefits the state had promised to its employees.

Rauner already had a backup plan in place. A state can’t declare bankruptcy. But local governments can, through Chapter 9 municipal bankruptcy. Rauner proposed changing state law to shift responsibility for the teachers’ pension to individual school districts, which could then file for bankruptcy protection as a way to dodge unpaid pension obligations. The gambit hasn’t gotten anywhere so far in Illinois, where a Democrat majority currently controls the legislature, but governors and legislators in other parts of the country could pick up the idea.

More than two years passed before the state passed its first budget under Rauner, and then only because enough legislators were scared that the schools wouldn’t open that fall that some Republicans crossed the aisle to overturn the governor’s veto. By finally approving a state budget in summer 2017, Standard & Poor’s declared at the time, Illinois had avoided the dubious distinction of becoming the first state the ratings agency ever saddled with a junk credit rating. As is, Illinois still has the lowest rating of any state in the country at BBB- , the final step before junk status.

Rauner left no doubt that he wanted a second term when he wrote a $50 million check to his re-election campaign halfway through his first term, in 2016. Again, he has the financial support of other hedge fund wealth, including $20 million from Kenneth Griffin. Yet this time, Rauner faces an opponent who is even richer than he is: J.B. Pritzker, with a net worth estimated at $3.2 billion.

Pritzker has promised that he would not solve the state’s budget woes by cheating the elderly out of money they are owed. “I believe it’s a moral obligation to live up to the commitments made to those who have been promised pensions,” Pritzker wrote in a candidate’s questionnaire from the Chicago Sun-Times. “While there’s no time to waste, Bruce Rauner has squandered three years with his unwillingness to compromise.”

Earlier this year, the nonpartisan Center for Tax and Budget Accountability in Chicago put forward a potential solution to Illinois’s seemingly unsolvable pension funding crisis, among the worst in the nation. Under its plan, said Martire, the group’s executive director, the pensions systems in Illinois would be 70 percent funded by 2045 “without cutting a dime in benefits.” Pritzker has endorsed the idea of refinancing the debt. But Rauner, the financier for whom these kind of deals are second nature, has not.

“He doesn’t want to solve the problem because the pension is the battering ram he’s using to try and break the public unions,” Martire said. “He needs to keep spinning the pension problem because he needs the unfunded pension liability to make the case that it’s the public unions that are destroying things in every state.”

This article was reported in partnership with The Investigative Fund at The Nation Institute.

Hedge Fund Dogs

In April 2008, a longtime investment adviser named Chris Tobe was appointed to the board of trustees that oversees the Kentucky Retirement Systems, the pension fund that provides for the state’s firefighters, police, and other government employees. Within a year, his fellow trustees named Tobe to the six-person committee that oversees its investments, becoming the only member of the committee with any actual investment experience. It was an experiment in fiduciary responsibility that ended badly. “I started asking questions when things weren’t sounding right,” Tobe said. “And a secret session was held where they voted to kick me off.”

Several weeks after he was removed, the remaining members of the committee approved a $200 million investment in a hedge fund called Arrowhawk Capital Partners. Tobe, though he remained a trustee, only learned about the deal after the fact, while reading the magazine Pensions & Investments.

In the years since that big Arrowhawk play, Kentucky’s public pensions have descended into financial crisis, a crisis that threatens to have ripple effects across the state. “Poor, rural counties in Kentucky have two major economic drivers,” state Rep. Jim Wayne explained. “One is the school system and the other is the courthouse. Most of them have no other industry.” Of the 120 counties in Kentucky, Wayne said, “government jobs is the No. 1 employer.” By 2016, the credit rating agency Standard & Poor’s declared Kentucky’s the worst-funded state pension system in the country. At that point, the state was meeting only 37.4 percent of its funding obligation — half the national median of 74.6 percent.

Tobe had never heard of Arrowhawk, and he quickly figured out why: Arrowhawk was a new fund whose first investor was the Kentucky Retirement Systems, or KRS. During his tenure as a trustee, KRS staff had proposed moving 5 percent — roughly $650 million — of the pension’s total holdings, then invested almost entirely in a mix of stocks and bonds, into large, established “funds of funds” — vehicles that allow investors to buy a basket of hedge funds, rather than risking everything on a single fund. Instead, the staff had steered the investment committee in 2009 to a startup fund with no track record. Tobe pressed the issue at several public meetings of the KRS board and eventually, in 2010, an internal audit revealed that Arrowhawk paid more than $2 million to a middle man named Glen Sergeon to land Kentucky as a client. KRS’s chief investment officer resigned during the course of the investigation (only to land a private-sector job as a managing director at a giant investment consulting firm). “Bad publicity, along with mediocre performance, sealed the fate of Arrowhawk,” Tobe wrote in his self-published book, “Kentucky Fried Pensions.” Two and a half years after Kentucky selected the firm for its first-ever hedge fund investment, Arrowhawk shut its doors.

More hedge fund investments followed, and Sergeon’s fingerprints were again on more than a few. In all, according to a subsequent probe by the state auditor, seven money management firms paid Sergeon a combined $5.6 million to persuade officials at KRS to entrust them with retirement dollars. That included Crestview Partners, another relatively new hedge fund, which paid Sergeon’s firm $1.1 million. Critics charge that the success of many placement agents, as intermediaries such as Sergeon are called, depends on their willingness to engage in various forms of pay to play, whether that means by contributing to the political campaigns of public officials with influence over a pension or by offering them lucrative jobs, consultancies, or loans. But in Kentucky, as in most states, it’s perfectly legal for hedge funds or private equity firms to employ placement agents — so long as they aren’t caught violating a fairly recent rule that bars them from giving campaign donations or financial benefits directly to public officials while those officials are in a position to send hundreds of millions of dollars to their clients.

Tobe suspected placement agents of bending the rules in Kentucky. In 2010, he filed a formal complaint with the Securities and Exchange Commission about the undue influence of placement agents in the state. The internal audit showed that in this one medium-sized state, in just five years from 2004 to 2009, placement agents were paid nearly $12 million to steer KRS business to clients. One placement firm, the Park Hill Group, until 2015 a subsidiary of Blackstone, a giant of the private equity world, collected $3.8 million in fees from 2005 to 2008. Together, Blackstone and Park Hill employ six lobbyists in Frankfort, the state’s capital. In all, according to the probe by the state auditor, placement agents secured $1.3 billion in investments for its Wall Street clients. And yet, Tobe said, “these early investments didn’t produce anything like the returns people were promising.”

A cautionary tale, perhaps. But it failed to give Kentucky pension officials pause. Despite scandals and poor performance, the staff, with the trustees’ blessings, shoveled even more of the state’s pension dollars into alternative investments, including hedge funds and private equity. The planned 5 percent for hedge funds doubled to 10 percent; additional funds were gambled on private equity. Today, 29 percent of KRS’s funds are invested in alternatives — well above the national average.

“The most important thing we do as fiduciaries is diversify our assets,” said Richard Robben, KRS’s interim chief investment officer. To Robben, alternatives add variety to a $17 billion pension fund that otherwise would have all of its money in stocks, bonds, or money market accounts. “It’s like grandma said, ‘Don’t put all your eggs in one basket.’”

Yet Kentucky’s heavy reliance on alternatives has come at a steep cost. Hedge funds and private equity typically charge “2 and 20” – 2 percent of every dollar invested, plus a 20 percent share of any profits. That works out to fees roughly 10 times what a pension fund would pay to invest in a plain vanilla stock fund. In 2009, the year it began investing in hedge funds, KRS paid $13.6 million in annual management fees. Five years later, that figure had ballooned to $126 million, according to a study KRS itself commissioned — more than twice as much as it had publicly disclosed in its 2014 filings. And that higher figure still didn’t capture all the millions of dollars in those 20 percent “performance fees” that hedge funds and private equity collect — sometimes many years into the future, after the sale of a successful venture — before distributing profits to investors. That same study underscored a second cost: Kentucky’s gamble on alternatives has proven a lousy investment. Had KRS simply matched the performance of the median pension fund in the five years ending in December 2014, the pension would have produced an additional $1.75 billion in earnings. If it had invested in a basic index fund matching the Russell 1000 (the country’s 1,000 largest public companies), KRS would have earned another $9 billion. Even investing the entire pension fund in a long-term bond fund — as safe an investment as there is, short of leaving it all in cash — would have meant hundreds of millions of dollars in additional profits during those five years.

Yet, incredibly, KRS kept investing massively in alternatives. It was only in 2017 that the KRS board voted finally to trim its holdings of hedge funds. Yet the fund continues to invest heavily in private equity. “There’s definitely been a ‘Hail Mary’ attitude in Kentucky,” Tobe said, a strategy of taking greater risks in the hope of making up yawning pension deficits. “But to me what it really boils down to is political corruption.” He’s hardly alone in that view. Former Goldman Sachs banker Susan Webber, writing as Yves Smith on the financial website Naked Capitalism, described KRS as “a contender both [for] the title of the most corrupt and the most incompetent public pension fund in the U.S.” Smith argues that Kentucky’s pension fund is so deeply underfunded “in no small measure to its dodgy relationships with placement agents, which in turn appear to have played a role in Kentucky Retirement Systems having invested in private equity and hedge fund dogs.”

A Mark for Wall Street

Chris Tobe was in his mid-30s, 11 years out from earning his MBA, when the state auditor’s office approached him about a job investigating Kentucky’s public pensions. Tobe had been working in Louisville as a portfolio manager at a regional bank, where he advised the very wealthy and large institutional investors. But he had also gotten involved in local Democratic politics and jumped at the chance to work in state government.

The Kentucky Retirement Systems is really three pensions in one. The state police have one pension, city and county employees another, and state employees a third. Teachers belong to a separate plan called the Kentucky Teachers’ Retirement System, or TRS. (Judges and legislators have another separate plan.) “I believe I was the first outsider ever brought in to give an assessment of how both KRS and the TRS were investing their money,” Tobe said, adding with a laugh, “I wrote my first report in 1997. I’m in my 21st year of being told I’ve been exaggerating the pension crisis.”

Tobe concluded that TRS was well run, at least back then, but he uncovered trouble at KRS, including a decision to bail out a large, Kentucky-based real estate firm teetering on default — which left KRS with a range of bad assets on its books from other parts of the country.

“There were a lot of crooked deals going on,” Tobe said. “But, really, it was nothing compared to what I saw happening once the hedge funds and private equity got involved.”

When Tobe left government in 1999 to return to the private sector, each of the pension funds had enough money to meet its financial obligations to retirees.

Politics in the state, however, were shifting. In 2000, Republicans gained a majority in the state Senate for the first time since the Great Depression — just as the country was entering a national recession, triggered by a bursting of the dotcom bubble. Revenues fell, demand for government services increased, and the state began to shortchange its pension fund. In 2003, Kentuckians elected their first Republican governor in nearly four decades. Five years later, the globe was hit by its worst financial crisis in 80 years. “Then we really didn’t have the money to fund pensions,” said Rep. Jerry Miller, co-chair of the legislature’s Public Pension Oversight Board.

“We couldn’t raise taxes. The Senate wouldn’t allow it,” explained Miller, a Republican who represents a slice of Louisville and its suburbs. “And we couldn’t cut services. The House, [controlled by the Democrats] wouldn’t let it. Everything became a battle between the two houses and the state pensions became a casualty.” The retirement system for Kentucky’s city and county workers was 59.7 percent funded in 2015; by 2017, that figured had dropped to 51.6 percent. There was a similar drop in recent years in Kentucky’s pension for state workers. A fund that was 21.9 percent funded in 2015 fell to 16.3 percent by 2017. The shortfalls were due primarily to government underfunding, rather than poor investments. But the greater the funding gap, the more the state became a mark for Wall Street’s more aggressive sharks.

Not every public pension in Kentucky is the same. By comparison, the retirement fund established for members of the state legislature is 85 percent funded. “Don’t even say it,” Miller said, holding up a hand during our breakfast at a Panera outside of Louisville. “Trust me, I’ve already heard it — from teachers, from firefighters, from others scared about what’s going on with their pensions.”

A Corrupting Influence

Tobe wasn’t primarily elevated to the KRS pension board for his investment experience. He supported a progressive Democrat for governor in 2007 and developed his pension platform. His candidate dropped out and endorsed fellow Democrat Steve Beshear, the eventual winner. “Part of the deal was my guy got some appointments out of it,” Tobe said. “I was one of them.” Beshear named Tobe a KRS trustee in the spring 2008, just as the stock market was beginning to swoon.

The fund’s investments in mortgage-backed securities lost more than half of their value, the result of recklessness and widespread fraud by bankers; total losses for the year neared $2 billion. Public pensions across the country faced heavy losses. Yet pension managers in Kentucky and elsewhere responded to the hit by piling more money into exotic investments. “Broadly speaking, you saw public pension across the country swiftly move to bail out Wall Street after 2008,” said Ted Siedle, a former SEC lawyer and pension consultant. “Just when they could least afford it, given big losses, they dramatically increased their holdings in the most expensive, highest risk investment products that Wall Street had to offer.”

I met Tobe at a Starbucks near his home in a wealthy suburb of Louisville. He’s a well-fed son of Kentucky with a round face and blue eyes, who rarely finishes one sentence before launching into the next one. “I go in 100 different directions,” he said. He confesses to voting yes when the staff recommended to the investment committee that they move 5 percent of the KRS portfolio into hedge funds. He found them a generally competent and experienced group, if also terribly overworked. (KRS’s chief investment officer has just four staff to help guide the system’s investments.) “They sold it to us as a diversifier to hedge against risk, but it really didn’t matter what they said,” he said. “Everybody was just rubber-stamping what they were told.” After he was stripped of his committee assignment, he used whatever pull he had in Frankfort to push for legislation that would require the committee to include at least one investment expert. In anticipation of that rule change, he was reinstated to the investment committee several months later. (Today, the committee must include at least two people with an investment background.)

In July 2009, the SEC proposed banning placement agents as a corrupting influence, sparking a debate that split pension fund officials across the country. “The selection of investment advisers to manage public plans should be based on merit and the best interests of the plans and their beneficiaries, not the payment of kickbacks or political favors,” then-SEC Chair Mary Schapiro said in proposing the ban.

The Third Party Marketers Association, a trade association for placement agents, sought to cast its members as a vital part of the public pension ecosystem — “marketers” there to help public pensions choose among competing funds. Tobe made his own view clear with an op-ed in the Lexington Herald-Leader: “KRS needs placement agents like a dog needs ticks,” he wrote.

By that point, Tobe had already pressed the KRS staff about its use of placement agents. He first brought up the issue at a public meeting in April 2009. But the staff denied any involvement with them, he recalled, and he took them at their word. “I knew there was pay-to-play going on,” he said — that the big funds were giving money to the right people to ensure that they received a share of pension dollars. “But at that point, I didn’t suspect placement agents because I couldn’t believe KRS would outright lie to me.” Four months later, the board, at Tobe’s urging, passed a placement agent disclosure policy. There were still no disclosures. Tobe later learned that during 2009, starting right around the time he first brought up the issue, the staff cut five deals with Sergeon, who was paid $4.4 million by hedge funds in just seven months to secure Kentucky investments. (What Sergeon might say for himself is a mystery. Sergeon, who died in 2013, told Forbes a couple of years earlier, “I don’t talk to reporters,” and hung up the phone.) When the staff finally acknowledged, in August 2010, that KRS had been working with placement agents for years, the disclosure was “buried” in a 50-plus page document, Tobe said. That same month Tobe filed a whistleblower complaint with the SEC.

The state auditor’s report, released in 2011, found no evidence of a pay-to-play scheme but documented “several troubling aspects regarding the use of placement agents,” including an “unusually close working relationship” between KRS’s chief investment officer and Sergeon, who set up appointments and made travel arrangements on the officer’s behalf. The officer resigned before the report was even out. KRS fired its longtime executive director and replaced its longtime board chair. It appeared to be a moment of reckoning.

Yet two months after the auditor’s report appeared, KRS committed another $1.2 billion to $1.5 billion to hedge funds — a set of investments so disastrous that a group of retirees filed a class-action lawsuit last December accusing the trustees and pension staff of failing in their fiduciary responsibilities.

Among the investments the suit singles out: the roughly $400 million KRS committed to Blackstone that year, over Tobe’s objections, and even though the firm was at the center of the placement agent probe. The investment was in Blackstone Alternative Asset Management, or BAAM, a fund of funds containing a range of hedge funds. That diversity came at a price. Buying into BAAM meant paying the fund-of-fund manager (typically a 5 percent share of profits plus a 1 percent management fee, according to Chicago Booth Review) on top of the already outsized expenses charged by each participating hedge fund. Investing in BAAM also meant owning a piece of SAC Capital, the infamous hedge fund operated by Steven Cohen that would later pay $1.8 billion in fines for insider trading and other crimes. Today there are 21 public pension funds in BAAM (but no longer Kentucky), according to Preqin, a research firm that specializes in alternative investments. “This is what’s happening nationwide,” Tobe said. “Kentucky’s just a little worse than others.”

Yet the SEC backed away from its plan to ban placement agents. Instead, the agency simply barred placement agents and money managers from making political donations to public officials with sway over a pension fund. But the agents could still legally contribute to PACs and Super PACs not associated with any specific elected official. “I’ve always assumed a portion of these fees somehow make it into campaign funds,” said Miller, the state representative. “Democrats and Republicans alike, there’s so many avenues for funneling them money.” The Supreme Court’s Citizens United made such giving even more opaque, Tobe said. “So you’ve created this system with a big, gaping corruption hole in it.”

Kentucky’s House passed a placement agent ban in 2011, as New York, Illinois, and other states had done, but the bill never became law. Instead, the state merely required placement agents to register as lobbyists.

After Tobe served his four-year term as a trustee, he wasn’t reappointed. He was already a former trustee when he learned, in 2013, that his whistleblower complaint had failed: The SEC, despite the millions of dollars placement agents were paid to steer KRS investments to their clients, announced that it would take no action against anyone involved.

In 2016, Tim Longmeyer, who served as a trustee with Tobe, was sentenced to nearly six years in jail after pleading guilty to accepting kickbacks in exchange for government contracts while serving as Governor Beshear’s secretary of personnel. One of his co-conspirators, a former Democratic political consultant named Larry O’Bryan, testified in a separate bribery trial that Longmeyer had once tried unsuccessfully to get him appointed to KRS’s board of trustees because there were “billions of dollars on that board.”

What’s Even in These Deals?

Randy Wieck, a high school social studies teacher in Louisville, had already been feeling nervous about the systematic underfunding of his pension when he discovered Tobe’s book. His future is in the hands of the state’s Teachers’ Retirement System, not KRS, but “Kentucky Fried Pensions” alarmed him. “You can’t bet your way out of the problem,” Wieck said. “But that’s exactly what Kentucky is trying to do.” Teachers, like any other public employees who don’t have Social Security withheld, are not eligible for Social Security benefits; even if they earn Social Security by working a side job, those benefits are adjusted downward based on their pension income. In Wieck’s case, his pension would be his main source of government support once he retired.

Wieck was the building rep for the local teachers union, yet he says union leaders brushed off his worries about the great risks the trustees were taking with teachers’ pensions and how little information the trustees seemed to be sharing with those relying on it for their retirement. “They tell me, ‘Yeah, we’re on top of it, we’re OK, don’t worry about it,’” Wieck said. “I was pretty much out there on my own,” said Wieck, a Louisville native with a graduate degree from the London School of Economics. “So I call Chris Tobe. I tell him, ‘You don’t know me from Adam, but I can use your help.’” The two met at a café outside of Louisville and had a conversation that inspired Wieck to press for more answers.

Wieck filed his first lawsuit against the TRS board of trustees in state court in November 2014. Lacking money to hire a lawyer, he typed up the complaint on his own and listed himself as the sole plaintiff in a class action charging the TRS trustees with failing to protect the pension from habitual underfunding — and making bad investments. When that suit was dismissed over jurisdictional issues, he refiled in federal court. A “corrupted system” and “KTRS’s mismanagement,” he wrote, had resulted in the “worst-funded teacher pension in the country.” Where once they contributed 9 percent of their salary to the retirement fund, teachers were now contributing nearly 13 percent. The local school districts were putting up their share each year. The state, however, was typically meeting only a half to three-quarters of its annual obligation, depending on the year. This time Wieck named two other plaintiffs and added four large money managers, including the Blackstone Group and KKR, as defendants. An underfunded retirement system, he charged, had inappropriately risked nearly $600 million with those firms during the previous eight months. That suit was dismissed on grounds that governments are generally immune from civil liabilities. (TRS has declined comment in reports on the suit, citing Wieck’s history of suing the agency.)

Wieck tried other avenues to expose what he saw as TRS abuses. He sent open records requests to TRS, which sent them along to several money managers, who claimed that the information was proprietary. One was KKR, which wrote requesting TRS to remind staff that their contract with the firm exempted them from sharing that information with anyone else, even beneficiaries of the fund. KKR, its representative wrote, considered all contracts, offering documents, and side deals with placement agents to be proprietary information. Hedge funds and private equity firms typically require investors to sign such confidentiality agreements even though, as Bloomberg Business Week reported in 2015, “much of what the industry wants to keep hidden has as much to do with high fees, weak oversight, and conflicts of interest as it does with business strategies or other trade secrets.”

“It’s so hard to know what’s even in these deals,” Tobe said of alternative investments. “A lot of this stuff’s offshore. You don’t even know what country your assets are in. You don’t know if they are even real.” The potential for corruption, given this lack of transparency, is extreme, Tobe argues. A case in point: In 2015, the manager of Camelot, a New York-based private equity fund holding $24 million of KRS’s money, confessed to falsifying financial records in order to embezzle $9.3 million. Tobe estimates that between them, KRS and TRS have 150 or more contracts with hedge funds and private equity firms —all of them operating without normal monitoring safeguards in place. “I have to pay into this fund from the first day I started working,” said Wieck, “and then they turn around and say we have no right to know what they’re doing with my money.”

“I think hedge funds are fine for individuals, but when it comes to public dollars, I’m leery,” state Sen. Joe Bowen, a Republican representing a district in western Kentucky, said. “When dealing with public money, we need to put those in the safest harbor you can find.” He has a similar view of private equity. Investing 10 percent of the state’s pension in dollars in alternative maybe made sense, Bowen said, “but certainly nothing near 25 percent.”

Sylvia Moore, who worked as food services director for the public schools in Mercer County, a rural county in central Kentucky, retired from the job in 2013. Moore, now 55, receives around $2,700 a month from the state, which includes her TRS pension and a small payment from KRS, the plan formerly associated with her position. Like Wieck, she lives in fear of any minor reduction to her modest retirement. “You pay into the pension all these years and just assume they know what they’re doing,” Moore said. She’s come to fear that actually there’s “a big pot of money sitting there and nobody watching it.”

Wieck is no diplomat. He has harangued union officials for failing to join his fight and they pushed back. It turned personal with at least one fellow teacher and led to a failed attempt to have his teaching license revoked by the Kentucky Education Professional Standards Board. “I’m very much a pariah,” Wieck said. “I’m blocked on many websites. On Facebook, on Twitter. As far I’m concerned, I think we need to be in the street with pitchforks and torches. But a lot of my colleagues want to believe what they’re told.”

“You Write Your Checks to My Guys”

Kentucky elected a new governor, Matt Bevin, in 2015. A tea party favorite, Bevin had bested two establishment Republicans in the gubernatorial primary to become only the second Republican in 40 years to be elected governor. Bevin stood out in a second way: He had been a partner in Waycross Partners, a Louisville-based hedge fund. “The country has three private equity governors,” Tobe said, referring to Bruce Rauner in Illinois, Charlie Baker in Massachusetts, and Gina Raimondo in Rhode Island. “But only Kentucky has a hedge fund governor.”

Bevin signed an executive order requiring staff and trustees of KRS to use money managers who agreed to comply with a code of conduct created by the CFA Institute, a global association of investment professionals. The order also required KRS to post all its contracts and offer documents online. They were important strides toward ethics and transparency — except both new rules have been routinely ignored, Tobe said. Many investment manager contracts are not yet publicly available, and KRS staff continues to invest in “all these private equity guys and hedge funds not on the list.” (The Bevin administration declined repeated requests for comment.)

Other reforms were troubling on their face. Calling for a “fresh start and more transparency,” Bevin disbanded the 13-member KRS board of trustees and replaced it with a new 17-person board of directors. By statute, the old board included six trustees who represented stakeholders independently elected by plan members — just shy of half the votes. Now the board would have four additional members appointed by Bevin. His picks included William Cook, who had recently retired from a job at KKR, and Neil Ramsey, a co-founder of the hedge fund BHR Capital, who now chairs the pension’s powerful investment committee. The Louisville Courier-Journal later reported that Ramsey had invested $300,000 in a business part-owned by the governor and had recently sold him a house in the Louisville suburbs for $1.6 million, hundreds of thousands of dollars below its assessed value. Bevin also fired the chair of the board of trustees, Louisville banker Thomas Elliott, a decision he enforced with armed state troopers to the next KRS meeting. “To me, that was a signal to Wall Street,” Tobe said, “that you don’t write your checks to Tommy anymore, you write your checks to my guys.”

But a new board also represented a shift inside KRS, said David Eager, who took over as the fund’s executive director in 2016.  KRS pulled back on its hedge fund investments and has become more selective about the private equity funds in which it put its money. “The new board hates paying fees,” Eager said. He also said in his two years as executive director, he’s yet to hear from a single official about a potential investment. “I can’t speak to political influence in the past, but it sure as hell is not happening now.”

Reform efforts in the legislature have proved equally frustrating to Tobe. In 2016, Bowen introduced legislation that required pensions to use an open process — complete with requests for proposals — when selecting money managers. “Competitive bidding is one of the basic principles of government,” Tobe said. “Except private equity and the hedge fund industry have taught every state and city government in the country that they’re above RFPs, that they should feel lucky that we’re willing to take your money.” In the end, private equity and the hedge funds got their way. The final bill Bevin signed into law last year included transparency rules and a code of conduct that both Tobe and Jim Wayne, a liberal Democrat from Louisville who has been pushing for pension reform for years, both described as watered down. And the RFP provision was dropped entirely. That’s just how the “sausage making” works, Bowen told me. “The point was driven home to me that we weren’t going to get into the best deals if we adopted an open process.” Even with the weaker disclosure rules, two financial firms have announced that they will no longer do business with KRS, including a New York-based hedge fund that in June cited the state’s transparency laws as its primary motivator.

As a candidate, Bevin had vowed to end public pensions altogether. Under his proposal, new employees would be enrolled in a “defined contribution plan,” like a 401(k), where the employee shoulders all of the risk — a substantial downgrade from the existing pension system, where KRS is responsible for paying out set benefits regardless of returns. In late 2017, he tried to mobilize a special session of the legislature focused on pension reform, but the GOP leadership couldn’t agree even on the outlines of a plan. Months later, and with no opportunity for debate, language was attached to a sewer bill, passed late one evening in March 2018, that ended pensions for teachers who are new hires in 2019, replacing them with defined contribution plans.

Randy Wieck got his teachers in the streets, carrying placards, if not pitchforks — finally angry in large numbers about their pensions, part of a national wave of teacher protests from Arizona to West Virginia. Thousands showed up at the Capitol, where Bevin’s counterattack made national news: “I guarantee you somewhere in Kentucky today,” he told reporters, “a child was sexually assaulted that was left at home because there was nobody there to watch them.”

The state’s attorney general, Andy Beshear — the son of Bevin’s predecessor and an announced challenger in 2019 — sued, arguing that the law that the governor had just signed violated the “inviolable contract” that the state has with its workers. A judge struck down the law on procedural grounds, as the bill, passed six hours after it had been introduced, failed to receive the required three readings any new bill needs under Kentucky law. The dispute is now in the hands of the Kentucky Supreme Court, which heard oral arguments in September.

Other pensioners in the state have also finally risen up, filing a class-action suit last December against a long list of plaintiffs, including KRS officials, the consultants they hired, and a veritable who’s who of Wall Street. The suit named the firm KKR and also its top two executives, Henry Kravis and George Roberts, along with Blackstone and its CEO, Stephen Schwarzman. The lawsuit charges that in 2011, KKR, Blackstone, and a third firm, PAAMCO or Pacific Alternative Asset Management, another deep-pocketed giant of the hedge fund world, sold KRS “extremely high-risk, secretive, opaque, high-fee and illiquid vehicles” that produced “poor returns and ultimately losses,” despite “excessive fees.” The hedge funds had sold the investments as an “absolute return strategy” that would help KRS meet or exceed its then stated goal of a 7.75 percent annual return on investment. Instead the investments had cost KRS millions of dollars in lost returns. Instead, the suit charges, there were steep losses due to “breaches of fiduciary and other duties” by those in charge who allowed themselves to be “to be taken advantage of by sophisticated Hedge Fund Sellers.” Though nominally a defendant in the suit, the KRS board voted unanimously to “commend” the plaintiffs for their suit, adding in a public statement, “a recovery in this litigation could go a long way in supporting the significantly underfunded retirement system.”

Don Coomer, a retired Louisville firefighter living in a modest suburb of Louisville, is one of the eight named plaintiffs. He first became a firefighter at age 19 and says he can’t remember a time when he wasn’t working a second job. The 67-year-old Coomer, whose shaved head, glasses, and gray goatee give him a Walter White look, says he was earning a salary of $50,000 when he left the department just short of his 30th anniversary. “I stayed for the pension,” he said, which works out to around $43,000 a year. Coomer qualifies for Social Security for those side jobs he worked all those years, but because of his pension, that benefit is only $387 a month, rather than closer to $1,000 he would otherwise receive. “It scares me to death that I’ll basically be making the same money I’m making today 20 years from now,” he said. “That’s a big concern.”

Asked why he got involved in the suit, Coomer said he wanted to do his part to help fix a system so broken that a practically bankrupt fund still wastes tens of millions of dollars on fees. “I don’t want just cash,” he said. “I want safeguards, to make sure people are doing a better job of watching over the money. We have to stop paying these crazy fees into the hedge funds.”

This article was reported in partnership with The Investigative Fund at The Nation Institute, where Gary Rivlin is a reporting fellow.

A Wall Street Coup

Thousands of Kentucky public school teachers swarmed the state Capitol earlier this year, angry not about low salaries, but about their shrinking pensions. Among their concerns: the high portion of their money that has ended up in the hands of Wall Street in opaque, high-cost products that seem to benefit no one aside from the people who sold them. Rising pension costs helped to send teachers in Colorado into the streets in protest a few weeks later. In the last year, pension woes have also prompted teachers in Ohio and Oklahoma to march. And police, firefighters, and other public employees in Michigan have been staging protests since at least 2016 to preserve their public pensions, more than one-third of which is invested in “alternatives”: private equity, hedge funds, commodities, distressed debt, and other opaque Wall Street investment vehicles.

A “Wall Street coup” — that’s how pension expert Edward “Ted” Siedle describes it. Public pensions across the country now squander tens of billions of dollars each year on risky, often poor-performing alternative investments — money public pensions can ill afford to waste. For all the talk of insolvency, $4 trillion now sits in the coffers of the country’s public pensions. It’s a giant pile of money of intense interest to Wall Street — one generally overseen by boards stocked with laypeople, often political appointees. “Time and again,” Siedle has written, “hucksters successfully pull the wool over these boards’ eyes.”

In 1974, in the wake of the spectacular collapse of the Studebaker car company and its pension plan, Congress passed a piece of landmark legislation, the Employee Retirement Income Security Act. Under ERISA, companies are required to adequately fund their pensions and follow what was then called the “prudent man” rule, which barred those in charge from putting pension dollars into overly risky investments. The departments of Labor, Treasury, and Commerce were charged with overseeing the country’s pensions and a new body was created, called the Pension Benefit Guaranty Corporation, that would backstop pensions should a business default.

Except Congress left out public employees entirely — with a yawning loophole that granted an exemption to public pensions. ERISA expressly exempts public pensions operated by state and local governments — the plans that provide for the country’s teachers, firefighters, police officers, and librarians in their retirement. Forty-four years after the passage of ERISA, these public workers comprise the majority of active employees still contributing to pension plans. And they have been left largely unprotected.

Siedle calls it “the loophole that is swallowing America.”

The public pensions loophole helps explain why we read a lot more about underfunded state or municipal pensions teetering on the edge of default than we do dangerously underfunded pensions in the private sector. Thanks to ERISA, private pensions are better funded, and when they do face default, the federal benefit guaranty kicks in.

Because ERISA’s adequate funding requirement exempts governments, there are some half a dozen states with pension systems at the breaking point, including Illinois, where lawmakers are wrestling with unfunded pension liabilities of $129 billion, and Kentucky, where the state’s unfunded public pension liabilities top $27 billion.

That ERISA’s fiduciary oversight rule also exempts governments helps explain how Wall Street pulled off its coup, according to Siedle, a former Securities and Exchange Commission lawyer who for decades has been investigating public pensions. Instead of the strong protections imposed on the private sector by Congress, Siedle notes, “public pensions are regulated by a thin patchwork quilt of state and local laws,” and many don’t even submit to an annual audit. “No federal or state regulator, or law enforcement agency, is policing these plans for criminal activity,” according to Siedle. “No worries about the Department of Labor or FBI.”

Until the 21st century, public pensions generally invested in a standard blend of stocks and bonds. The more daring or community-minded among them may have invested a small fraction of their holdings in real estate projects or other exotic investments, yet alternatives averaged only 5 or 6 percent throughout the 1980s and 1990s. Yet as alternative investment structures grew in recent decades, and as pension funds sought desperately to make up for funding shortfalls, more and more of those trillions of dollars made their way to the country’s hedge funds and private equity managers. When, in 2017, the Pew Charitable Trusts looked at 73 of the country’s largest public pensions, researchers found that a full 25 percent of the pension money was invested in these high-fee alternatives.

The irony is that pensions don’t need to be 100 percent funded to be sound, as employees don’t all retire at once. Rating agencies and government monitors typically consider 70 to 80 percent to be adequate. And the country’s public pensions are generally hitting that mark, averaging 76 percent funding as of 2015, according to a survey by the National Conference on Public Employee Retirement Systems. “To suggest that there’s some nationwide crisis is simply not true,” says Bailey Childers, former director of the National Public Pension Coalition.

Yet public pensions continue to make desperate investments — and the competition for a piece of that action is so intense that it’s often involved outright fraud. It was in part a pension sting operation that helped take down Illinois Gov. Rod Blagojevich, who was back in the news earlier this year when President Donald Trump floated the idea of commuting the sentence of his former “Apprentice” star. In New York, Comptroller Alan Hevesi, who oversaw a $125 billion pension fund, confessed in court in 2010 that he had signed off on a $250 million pension investment in exchange for nearly $1 million in illegal gifts from a man named Elliott Broidy. Broidy, who ultimately pleaded guilty to a misdemeanor, is a major political donor with close ties to Trump; so close, in fact, that he resigned as deputy finance chair of the Republican National Committee this past April after it was revealed that Trump’s personal lawyer, Michael Cohen, arranged a $1.6 million payoff to a pregnant former Playboy model, allegedly on his behalf. Pension scandals have touched the Carlyle Group, a well-feathered landing spot for retired public officials (including former President George H. W. Bush and former British Prime Minister John Major), and also some of the biggest names in money management on Wall Street. In July 2018 alone, the SEC sanctioned private equity firms and other investment advisers for violating its “pay-to-play” rules — in Texas, Wisconsin, Indiana, Illinois, Rhode Island, and Los Angeles.

A scandal in California didn’t involve any high-profile elected officials but was, if anything, even more outrageous. There, the CEO of the country’s largest public pension was brought down by a pay-to-play scheme involving a former trustee and billions of dollars in public funds. Fred Buenrostro ran the California Public Employees’ Retirement System from 2002 to 2008. Alfred J.R. Villalobos, a former CalPERS trustee who became a placement agent, allegedly paid for Buenrostro’s wedding, took him on a trip around the world, and paid him hundreds of thousands of dollars stuffed in paper sacks and a shoebox. In exchange, prosecutors charged, Villalobos secured more than $3 billion in CalPERS investments for his client, Apollo Global Management, a giant of the private equity world. Over a five-year period, Villalobos earned around $50 million for helping his private equity clients win deals with CalPERS; he pleaded not guilty but took his own life before trial. Apollo’s punishment was the additional $550 million it received from CalPERS in 2017.

Yet much of what Siedle called the “looting” of the country’s public pensions takes place through perfectly legal investments with exorbitantly high fees. As an example, he brings up Rhode Island, where he spent time in 2013 after one of the big public employees’ unions, AFSCME, hired him to investigate the state pension there. Rarely was the wealth transfer from workers to Wall Street as vivid. The new state treasurer, whose campaign had been bankrolled by several New York hedge fund managers, championed a plan that cut employee benefits by roughly 3 percent several years back — and then gave most of the money the system saved to a trio of hedge funds to which it had entrusted a big chunk of its investments. “It wasn’t an austerity program,” Siedle said. “It wasn’t reformed. It was simply about paying lower benefits so Wall Street could get paid.”

The High Price of Hedge Funds

Hedge funds and other more exotic investments come at a steep price. A pension fund seeking to own a diverse basket of technology stocks, say, or invest in promising, mid-sized European companies may hire a stockbroker to handle that aspect of its portfolio for around 0.5 percent annually, or $500,000 a year for every $100 million invested. By comparison, hedge funds and private equity charge fees that work out closer to 5 percent annually, according to Howard Pohl, an investment consultant who has been advising public pension managers for more than four decades. Yves Smith, the pen name of management consultant Susan Webber, puts that figure closer to 7 percent a year on private equity investments. That’s $5 million to $7 million each year on every $100 million a pension invests with a firm. The deal has worked out well for some of Wall Street’s best-known billionaires, including Stephen Schwarzman, CEO of the Blackstone Group, who pocketed $787 million last year; Henry Kravis and George Roberts, the co-founders of Kohlberg Kravis Roberts, who took home a combined $343 million in 2017; and Steve Cohen, the disgraced hedge fund king worth an estimated $13 billion. All of them included public pension funds among their major clients.

The pensions haven’t fared nearly as well. The 2017 Pew study found that those funds that had recently and rapidly invested in alternatives reported the weakest 10-year returns. A 2018 report by the conservative Maryland Public Policy Institute put a price tag on those mediocre results. The group compared the actual performance of the $49 billion Maryland State Retirement and Pension System against a model with a straightforward “60-40” approach, in which 60 percent of a portfolio is invested in stocks and 40 percent in bonds. Despite the hundreds of millions of dollars in additional fees the pension system had paid to private equity firms and hedge funds, it would have earned an additional $5 billion over the prior 10 years had it adopted the more judicious 60-40 strategy. A 2015 study commissioned by the then-$15 billion Kentucky Retirement System found that overexposure to hedge funds contributed to more than $1 billion in lost returns over five years when compared to the returns earned by its more cautious peers. A study that same year by the liberal Roosevelt Institute and American Federation of Teachers found that poor returns on hedge fund investments had cost 11 of the country’s larger statewide public pensions $8 billion in lost revenue over the previous decade because most of the profits were eaten up by the steep fees hedge funds charge their investors.

“I could never figure out why somebody working at a hedge fund is worth 10 times more than the guy at Fidelity,” Pohl said.

Citizens United, the landmark Supreme Court decision that ushered in a boom in political dark money, also accelerated the siphoning off of billions of pension dollars into inappropriate investments. “Since Citizens United, investments in alternatives have absolutely exploded,” said Chris Tobe, a former trustee for the Kentucky Retirement System. Wall Street firms can now write big checks to a political or party committee to curry favor among elected officials who control pension fund appointments — completely out of the public view. A new SEC rule that year imposed tight restrictions on political contributions by hedge funds, private equity firms, and others to any public official who could have sway over an investment decision. Yet Citizens United effectively made the rule irrelevant, as money flooded in to proxies instead. Executives at firms managing state pension money gave $6.8 million to the Republican Governors Association in the 2014 election cycle, according to the nonprofit MapLight, and $151,000 to its Democratic equivalent.

Much of the overreliance on private equity and hedge funds boils down to what Ted Siedle sees as a mismatch between the civil servants, who work for the public pensions, and the salespeople, who show up with their sophisticated marketing materials and pitches that make it sound as if only a small elite is fortunate to get a piece of the hot, new fund they are peddling.

“You’ve got Wall Street marketers with virtually unlimited expense accounts, under orders by their bosses to do anything necessary to win over these government pension officials who control trillions,” Siedle said. “So people living these mundane lives are being flown to five-star hotels in Maui, in Honolulu, in Phoenix, in Puerto Rico, in Bermuda. They’re being flown to New York, where they see the hottest Broadway shows, or they’re in Las Vegas at Cirque du Soleil. I’ve seen everything from trips to strip clubs to helicopter rides over Maui to hot-air balloon rides in Albuquerque.”

Violations of Trust

Persuading a pension fund to invest requires a money manager to win over the two main groups guarding money promised to retirees. There’s the staff that makes the investment recommendations. “For the most part, these are very hardworking, good people who sometimes are in above their heads,” Pohl, the consultant, said. There’s also the boards appointed to oversee a fund.

Who sits on a board of trustees, and how well they’re positioned to oversee the staff, varies widely from jurisdiction to jurisdiction. Some boards are designed to be political. The body overseeing New York City’s Employees’ Retirement System, for instance, consists of 11 political players: the city’s five borough presidents, the city comptroller and public advocate, a mayoral appointee, and the heads of the three unions who represent the largest number of participating employees. New York state’s Common Retirement fund, the third-largest public pension in the country, with more than $200 billion under management, is overseen by a single individual: the state’s elected comptroller. In Chicago, the teachers run the show, with teachers and former teachers constituting a majority on the board overseeing the Chicago teachers’ pensions.

Technically, the trustees determine asset allocation: the portion of a fund’s money that is invested in stocks and bonds and alternative assets. But it’s typically the staff that recommends any changes, or proposes that a fund choose a new money manager or steer more money to an existing one.

In theory, the trustees serve as a check on staff. But only in rare circumstances do they aggressively exercise that authority. After major losses at the Chicago Teachers’ Pension Fund following the 2008 crash, an insurgent group of public school teachers ran for and won the two open board seats the following year. One of those insurgents, high school English teacher Jay Rehak, who today serves as board president, said, “Unfortunately, a lot of these people on boards are essentially bobbleheads” — built to nod their heads yes. The insurgents, who now run the city’s teachers union, removed the remaining bobbleheads in subsequent elections, according to Rehak. Though roughly 3 percent of the $10.1 billion is in the hands of private equity managers, he said, “we’re now 100 percent out of hedge funds.” But it wasn’t without pushback from staff.

“We’d fire fund X, Y, and Z,” Rehak said, and invariably someone on the pension staff would complain,“‘But they’re our friend.’ I tell them, ‘Don’t worry, they’ll land on their feet.’ It might sound crazy, but these people are very good at selling themselves.”

Pension investment staff typically earn dramatically more than the civil servants whose money they are investing. CalPERS, for instance, paid its chief investment officer $867,000 last year — while the state’s chief executive, its governor, earned a fraction of that, $190,000. The CIO of the Teacher Retirement System in Texas is paid $450,000 a year; four others on his staff (like him, all white men) are paid annual salaries exceeding $325,000 — more than twice that of the state’s governor. Idaho’s CIO was paid just over $300,000 last year — two-and-a-half times as much as the governor. “Some of these salaries are out of control,” said Tobe, who calculated, based on performance data from Boston College’s Center for Retirement Research, that there was no correlation between how well a CIO is paid and performance.

Tobe learned the hard way how conflicted pension fund staff can be during his four years as a trustee of the Kentucky Retirement System. The staff was particularly adept, Tobe said, at keeping secrets from their ostensible bosses, the trustees. Only near the end of his tenure did Tobe learn that one key staffer who helped push the state more aggressively into alternative investments sat on more than a half-dozen advisory committees created by the private equity partnerships and hedge funds he had been paid to assess. “Funds create advisory committees and then put staffers from the public pensions on them, along with union people and people from the endowments and foundations, whose money they also want,” according to Tobe, who added that committee members don’t typically receive a stipend, but rather extravagant perks, such as complimentary stays at $1,000-a-night hotels in exotic locales. “It’s basically a boondoggle,” he said. “They’ll take them offshore, show them a good time, buy them expensive meals.” The quid pro quo is that a pension fund will invest with that firm.

The third important players in pension decision-making are the consultants that pension funds hire to guide their decisions and vet the money managers seeking a piece of their business. Investment consultants, too, are often conflicted. While Siedle speaks approvingly of And Co, where consultants such as Pohl help pension funds “make sure they’re not a bunch of sheep at the mercy of the wolves,” in Pohl’s words, sometimes the investment consultant is the wolf. Recently, Siedle completed a job for Orange County, in Florida, whose comptroller hired him to evaluate seven investment consultants who had applied to advise the fund. “I concluded that six out of the seven were conflicted,” Siedle said. They were being paid on the side to help one money manager or another market its services to funds such as Orange County’s, if not earning a commission whenever a pension invests in funds they peddle. “Only one was not in the money-manager business,” Siedle said, noting, “that’s typically the case.”

Yet even those pension consultants without direct financial ties to a hedge fund or private equity firm have a troubling conflict of interest that not incidentally drives up the fees that pensions pay. Pension consultants advise funds on its optimal mix of assets and often recommend the best managers to handle those assets. A consultant taking into account a pensions’ best interests might steer clients into inexpensive options, such as index funds, which let investors own a diverse portfolio of stocks at a very low cost. (A Standard & Poor’s 500 index fund, for instance, follows the price movement of the country’s 500 largest publicly traded companies.) Index funds typically charge annual fees well below 0.5 percent, but don’t require much in the way of billable hours for the ambitious pension adviser. Helping a pension fund choose among the thousands of hedge funds peddling its services, however, could lead to hundreds of hours of charges. “In the consulting business, you’re not making much selling clients on low-fee index funds,” Siedle said. Suggesting that a pension hand over a portion of its cash to hedge funds and private equity is far more lucrative, he said. The consultant earns fees helping a pension navigate a complex world of options — and then potentially earns much more serving as the indispensable gatekeeper who gets them into a fund.

Even the most well-meaning consultant may have trouble protecting a pension fund from alternatives, Siedle said. “They have clients insisting on being in alternatives,” Siedle said — pension fund managers who are convinced that alternative investments add octane, despite the risks and the record. So the consultants “can’t be talking in the press about how pension managers are idiots if they own this shit.”

A Lucrative Source of Profits

It wasn’t that long ago that public pensions were cautious players almost afraid of the stock market, let alone the dice-rolling of investments in hedge funds. Teresa Ghilarducci was a labor economist at Notre Dame when, in 1997, Indiana’s governor named her to the state’s Public Employment Retirement Fund’s board of trustees. “The big debate then was whether we should go beyond bonds and invest in stocks,” said Ghilarducci, who now teaches at the New School in New York. “I was a detractor who thought we were moving too fast.”

By the time she left the board in 2002, the trustees were already considering hedge funds and private equity. Today, nearly 37 percent of Indiana Public Retirement System assets are invested in alternatives. According to Pew, it was the single worst-performing pension fund in the country over the decade ending in 2015.

The health of public pensions in the United States more or less peaked around 2000. On average, state and local pensions were 103 percent funded that year, according to Boston College’s Center for Retirement Research, with more money on hand than they even needed. At that point, only 3 percent of public pension dollars were invested in alternatives. But then the dotcom crash caused a steep fall in the stock market, with the Nasdaq index dropping by 77 percent and the S&P 500 by 43 percent. Pensions that had been more than fully funded in 2000 now had only 90 percent of the money they needed on hand. What happened next is what Ghilarducci describes as “chasing returns” — dialing up the risk to fill the gap. “I’ve seen it a lot: funds shooting for the moon because they’re trying to catch up” said Ghilarducci, co-author of a 2016 book, “Rescuing Retirement.”

As the hedge funds and private equity firms moved in, so did another actor: the placement agent. Pensions were such a potentially lucrative source of profits for any hedge fund or private equity firm — able to invest tens of millions, if not hundreds of millions of dollars, at a time — that money managers began to hire intermediaries to help convince pension funds to invest with them. At their most benign, placement agents are well-compensated salespeople, helping public pensions gain access to better investments. Time and again, though, “placement agents” have been shown to function more as political fixers who use their connections, campaign contributions, and even outright bribes to influence the staff, trustees, advisers, or elected officials who have the capacity to help steer pension dollars into the coffers of one of their clients.

In fact, the federal wiretap that caught Blagojevich trying to sell Barack Obama’s soon-to-be-vacated Senate seat for $1.5 million had been put in place during an investigation of the influence of placement agents inside the Illinois teachers’ pension fund (as well as possible kickbacks related to state health facilities). Among those that Operation Board Games — as the U.S. Attorney’s Office and FBI dubbed their investigation — targeted was Tony Rezko, who was found guilty in 2008 of scheming with Teachers’ Retirement System trustee Stuart Levine to get kickbacks from a money management firm seeking some of the pension fund’s money. (Levine also went to jail.) Blagojevich aide Christopher Kelly killed himself after being indicted as part of a conspiracy to block a $220 million investment with Capri Capital already approved by the TRS board unless Capri donated to Blagojevich’s re-election campaign. A third man, William Cellini Sr., delivered the threat by giving Capri a choice: raise $1.5 million for Blagojevich or kiss the $220 million deal goodbye. Cellini was found guilty in 2011. The probe also uncovered evidence that the Carlyle Group had paid $4.5 million to a lobbyist to gain a share of the union’s retirement money as well. Carlyle was never charged with a crime.

By 2009, the problems with placement agents had become so visible that the SEC proposed a ban on them. But after intense lobbying by the likes of Blackstone and Morgan Stanley, both of which have placement agent divisions, the SEC backed down. New York, California, and New Mexico imposed restrictions on the use of placement agents that year. But a 2014 study found that placement agents were still being used by 41 percent of the North American-based private equity firms raising funds that year.

In the late 1990s, Siedle thought there was money to be made consolidating the pension consultant market and convinced Bruce Rauner, then a big-time private equity manager in Chicago, to commit up to $250 million to the idea. But the business never went anywhere. The small consultancies he imagined buying up with Rauner’s cash had no interest in selling, he said; many of them had devised their own pay-to-play schemes and were making too much money. It turned out that the fees they were paid for their guidance — the part of the business Siedle wanted to own — represented only a fraction of their earnings. Consultant after consultant told him how they were making more money on commissions by acting as a pension’s broker and hosting conferences for the pension’s money managers, who paid as much as $50,000, Siedle said, to “market their wares to the consultants and pensions in the crowd.” Others were making their money by doing dual duty as consultant and broker. Siedle figured that they stood to earn far more money charging brokerage fees than they earned for their advice. The Chattanooga Pension Fund in Tennessee accused a pension consultant of costing them $20 million from its fund through “churn”— buying and selling shares to produce higher trading commissions. A similar controversy in Nashville led to a $10.3 million settlement between the city and its consultant.

The 2008 financial crisis proved another accelerant for alternative investments. The crash caused the country’s public pensions to lose billions of dollars in value, due in part to their heavy exposure to mortgage-backed securities and other subprime-related products. By 2009, public pensions across the country were only 79 percent funded. In a later blog post, Siedle calculated that because of the subprime meltdown, $660 billion in state workers’ retirement savings “have been taken off the radar — swept into the highest-cost hedge, private equity, venture and real estate funds ever devised by Wall Street.” By his estimation, it was “a heist 40 times greater” than Bernie Madoff’s Ponzi scheme. A few years later, Siedle uncovered evidence that JPMorgan Chase had failed to disclose conflicts of interest to some of its wealth management clients, leading the bank to pay a $300 million fine — earning Siedle $78 million in whistleblower awards from the federal government.

One rationale reaction to 2008 would have been for pension fund managers to swear off exotic investments and go back to plain vanilla stocks and bonds. Instead, many doubled down, hoping higher returns would help make up for their severe losses. Siedle calls this the “Hail Mary,” the football term when a team that’s behind late in the game throws a desperation pass in the hope of a big score. It’s a vicious circle; the more some locales fall behind, the more its people gamble on alternatives — and it’s taxpayers who are on the hook for any shortfalls.

Gambling, Not Investing

Despite the steep fees, some financial experts believe that hedge funds and private equity are appropriate for a pension fund — in moderation. One is Ghilarducci, the former Indiana trustee who is now a trustee for two union funds. She said, “It would be a violation of my fiduciary duty if we did not invest in hedge funds or private equity.” But she cautions that only a small universe of money managers in those categories can be trusted with a pension’s money, and that even so, they are appropriate only for larger pensions with the requisite staff. “The evidence is showing that most hedge funds aren’t worth the risk or the high fees,” she said. “And most private equity isn’t, either.”

Mark Hoffman is another believer. As the head of alternative investments for PNC Asset Management, he advises wealthy individuals, as well as institutional investors like pension funds, on how they should invest their money. “Twenty years ago, you could get a 7.5 percent return investing in bonds,” Hoffman said. “Today, it’s almost impossible to achieve a 7.5 percent return without doing something in the alternative space.” But at PNC, he said, they hold to a hard-and-fast rule: no more than 30 percent in what Hoffman calls “private investments” — private equity, hedge funds, and real estate.

A partial list of states that have blasted through that cap is long and includes Illinois, Kentucky, Massachusetts, Michigan, Ohio, South Carolina, Texas, Utah, and Vermont, each of which recently had at least one-third of its portfolio in alternatives, according to the 2017 Pew study. Two states have large pension funds with more than half their money in alternatives: the Missouri State Employees’ Retirement System (51 percent) and the Arizona Public Safety Personnel Retirement System (56 percent). “At that point,” Siedle said, “that’s what I’d call gambling, not investing.” The consultant in charge of Arizona’s public safety pension released a statement declaring that the move into alternatives was about reducing the risk of an overreliance on stocks — even as he acknowledged that three-quarters of its peers had outperformed the fund.

The founders of hedge funds and private equity partnerships tend to be Wall Street refugees who were making millions a year working for a Goldman Sachs or Morgan Stanley, but figured out that they could make even more in alternatives. The key to that wealth is the “2 and 20,” as it is called within the industry. Hedge funds and private equity alike typically collect a 2 percent management fee ($2 million for every $100 million invested) and then take 20 percent of any profits before distributing them to investors. Double that $100 million over a 10-year period, and reward yourself with a $20 million performance fee. The beauty of the “2 and 20” is even if a $5 billion fund makes no money for its investors, it still walks away with $100 million in management fees.

Hedge funds and private equity are lumped together in the alternatives category for good reason. Both are giant pools of opaque money that are largely unregulated, precisely because they are open only to so-called qualified investors — the very rich or large institutional investors like pension funds.

Yet there are big differences between the two. Private equity buys companies, or large pieces of companies, and often requires investors to lock in their money for 10 years or more. Hedge funds, by contrast, basically do what they want. They can buy stocks or short stocks (that is, bet that a stock’s price will fall) or simply invest everything in a money market. They can make a $1 billion bet against the British pound, as George Soros famously did in 1992, or invest everything in collateralized debt obligations and other esoteric subprime-related products, as a pair of Bear Stearns hedge funds fatally chose to do before their collapse in 2007. Since hedge funds tend to invest in things bought and sold on the open market, a pension fund wanting out can usually extract its money within 30 to 90 days.

Of the two, private equity is the easier investment for a trustee to rationalize. Despite the steep fees, private equity has proven a good investment. Private equity firms have generally outperformed the stock market, even factoring in the enormous fees. Yet Siedle still questions their inclusion in a public pension portfolio, as they mean that a pension has no say over how its money is invested. Private equity might provide the needed capital to help a business grow and allow everyone to prosper. It might also hollow out a company and sell it off for parts, leading to the loss of thousands of jobs. At least 11 public pensions are helping to fund the Trump family as investors in the CIM Group, a private equity partnership that owns the Trump SoHo and pays the Trump Organization to run it. In August, the AFT released a report identifying 26 hedge funds that have billions of dollars invested in private prisons and urging public pension trustees to divest in order to avoid “rely[ing] on incarcerating people to turn a profit.”

Hedge funds, on the other hand, barely offer an upside. In 2008, famed investor Warren Buffett bet $1 million that a passive investment in an S&P 500 stock index fund would outperform hedge funds when factoring in fees and other expenses. Buffet collected his wager several months early, in the fall of 2017, because the contest wasn’t even close. The S&P 500 had generated a return of more than 7 percent a year since the start of 2008, compared to 2.2 percent earned by a basket of hedge funds.

The exposure of so many pensions to hedge funds is a tribute to the influence of marketing departments and placement agents — and the intense pressure that trustees and staff feel to rev up returns with the high-octane investments they crave.

Some pensions around the country have long bucked the alternatives trend. Oklahoma has no money in alternatives and yet has posted a 10-year return of 6.99 percent per year, according to Pew’s 2017 study of the country’s largest funds. Neither does the Georgia Employees’ Retirement System or its Teachers Retirement System, yet both show a 10-year return of nearly 7 percent. Both fared better than Arizona’s public safety fund, the state pension with the greatest exposure to alternatives, which earned only 5.2 percent a year.

A handful of other locales that were once heavy users of alternatives have recently cut back. One is the New York City pension system, which, at $192 billion, is the fourth-largest in the country. A 2015 study released by Scott Stringer, the city’s comptroller, found that the city had paid billions to those he called “Wall Street money managers” — and yet he found that those fees and underperformance had cost the pension system $2.5 billion over the previous decade. In 2016, trustees of the New York City Employees’ Retirement System voted to shed its hedge fund holdings. That followed a 2014 decision by CalPERS to liquidate its $4.1 billion hedge fund portfolio. (CalPERS has hardly sworn off its addition to alternatives. Earlier this year, Bloomberg reported that its trustees were reviewing proposals from six firms, including BlackRock, the giant investment management company, to oversee nontraditional investments. Smith, the financial blogger, points out that this approach “flies in the face of what every other major investor in private equity is doing, which is to do more in-house, both to reduce fees directly and, over time, to gain more leverage over private equity.”)

The pushback has also extended into North Carolina, where in 2017 Dale Folwell took over as state treasurer, the first Republican to hold the position in 140 years. Folwell ranked as one of the legislature’s most conservative members during his eight years in the North Carolina House, where he was a vocal opponent of same-sex marriage and civil unions. Yet as treasurer, he has been an outspoken critic of high-priced alternative investments and has sought to shift most of the state’s $96 billion pension fund to a mix of low-cost index funds. He found that the state had paid $600 million in fees in 2016 — seven times more per dollar under management than it had paid in 2000 when it had fewer alternative investments — yet had posted only a 5.1 percent return over the previous 10 years.

Folwell, as treasurer, has sole discretion over how the pension invests its money; the North Carolina pension system’s board of trustees has no authority to curb his instincts. But he’s found that change isn’t easy when it comes to private equity. His predecessors, he discovered, had signed long-term contracts that locked up the pension’s money. Though in 2017 the fund pledged to invest no new money in private equity, extracting the state from its prior private equity commitments would require selling in the secondary market at fire-sale prices. As a frustrated Folwell told the Wall Street Journal earlier this year, “It’s hard to come into a culture where no one thinks anything is wrong.”

This article was reported in partnership with The Investigative Fund at The Nation Institute.